Why You Should Consider ESG as a Driver of Portfolio Risk & Return

– ESG factors drive corporate financial performance, hence shareholder return

– Investing in market benchmarks optimized to include ESG factors or tilting portfolios to specific components of ESG is now easily accessible and inexpensive through the use of ETFs

– Advisors can easily differentiate their “value add” to their clients and prospects through efficient, active, transparent and liquid use of ESG ETFs

ESG refers to the integration of (E)nvironmental, (S)ocial, and (G)overnance factors in the investment process. There have been several approaches to integrating these factors over the last several years including exclusionary screens (socially responsible), ESG integration (sustainable investing), and impact investing (targeting and measuring specific social and environmental outcomes).

Historically, many investors kept their personal investments separate from charitable donations reflecting individual values and passions. Also, investors assumed that mixing the two would detract from investment performance, and it may have, if the approach was solely focused toward socially responsible investing with an eye on “excluding” investment securities.

The most recent trend indicates that asset managers, wealth managers, and investment advisors have adopted the practice of integrating ESG into their core investment process (Source: US SIF; http://www.ussif.org).

This trend has been driven by market demand and evidence that careful inclusion of ESG factors can improve risk adjusted results. Carefully optimizing on ESG scores, while neutralizing other systematic risks in the portfolio such as sector, country, and beta, has provided added value in the past. There are several empirical studies that support the argument that integrating ESG factors into the portfolio construction process can improve risk adjusted results.

An MSCI study concludes that asset managers who would have integrated ESG scores into the investment decision, through various optimization approaches would have produced portfolio results with higher risk adjusted results and higher total ESG scores than a market cap weighted benchmark (MSCI: Optimizing Environmental, Social, and Governance Factors in Portf0lio Construction – Dec. 2012). The same conclusion was drawn from a study by Friede, Busch, and Bassen: ESG and Financial Performance: Aggregated Evidence from more than 2000 Empirical Studies (Journal of Sustainable Finance and Investment: Dec. 2015).

This article was contributed by Palladiem, a participant in the ETF Strategist Channel.

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